The Striking Price

Set for Another Facebook Debut?

Puts and calls on the social-networking company begin trading Tuesday, and in view of the troubles at the stock's initial offering, and the shares' behavior since, implied volatility is expected to be unusually high at first.

Because the stock (ticker: FB) has behaved so atrociously since the initial public offering, the options are initially expected to be too expensive to buy and too cheap to sell when they begin trading Tuesday.

"On Day One you will be able to drive a truck through the spreads." predicts a senior executive at a major Wall Street firm. "Don't buy options until she settles in."

In other words, the prices at which dealers will be willing to buy and sell—the bid and ask—are expected to be wide in reflection of the uncertainty about Facebook's stock price. Wide spreads create more profits for dealers. Wide spreads mean bad prices for investors.

But if only it were that simple. Options prices are more nuanced than just quoted market prices.

Implied volatility, which is the most critical and most subjective part of options pricing models, is expected to initially be unusually high and elastic when Facebook's options begin trading. Dealers will likely set implied volatility at 50% to 55%, keying off the volatility of other social-media stocks, including
LinkedIn
(LNKD),
ZyngaZNGA -2.6578073089700998%Zynga Inc. Cl AU.S.: NasdaqUSD2.93
-0.08-2.6578073089700998%
/Date(1481320800164-0600)/
Volume (Delayed 15m)
:
14898928AFTER HOURSUSD2.93
%
Volume (Delayed 15m)
:
51753
P/E Ratio
N/AMarket Cap
2684752050.30743
Dividend Yield
N/ARev. per Employee
441371More quote details and news »ZNGAinYour ValueYour ChangeShort position
(ZNGA) and
Google
(GOOG), which some dealers reference because it is, like Facebook, a large-capitalization stock.

A 55% implied volatility implies Facebook's stock will move about 3.4% each day, a level that could prove too conservative, or not conservative enough. The talk in the options market is that Facebook's volatilities will initially be, according to one senior exchange executive, "super-high, and that's a recipe for volatile volatility."

So even if Facebook's options are priced at 55% implied volatility, the volatility could drop to 45% or surge to 85% depending on options demand and stock action.

"No one knows how to set Facebook's volatility," says a senior trader at a top options market-making firm. "If no one's pricing models agree, volatility will move around as the models bump into each other."

And then there is the issue of all the investors who think Facebook's stock is poised for a nasty fall. Not a Pets.com dirt nap, but a strong correction reserved for any stock that trades over 75 times earnings. Initial options strike prices will be as low as $16, or about 40% below Facebook's stock price.

BECAUSE SO MANY INVESTORS want to short Facebook's stock but can't borrow shares, a lot of them are expected to buy Facebook's puts since puts rise in value when stock prices decline. In anticipation, options dealers will likely raise volatility to offset the risk of effectively being short Facebook stock. If they have to sell puts—and they do—they are effectively letting other investors short stock, and that creates problems for dealers who must offset the risk.

Despite those difficulties, the uncertainty around Facebook will prove extremely attractive to many aggressive investors. They will want to sell Facebook's high-priced puts to bet that implied volatility will ultimately settle at a lower price as dealers better understand options and stock trading patterns. We even recommended this strategy, but that was before Facebook's IPO proved so problematic.

If you decide to trade Facebook's options on Tuesday, use limit orders. If you use market orders, you will get steamrolled. In fact, some banks are limiting market orders on Facebook to 500 contracts, down from 10,000, on the first day Facebook's options trade to prevent the kind of fiasco that occurred in the stock market.

Limit orders let you pick the price you want to buy or sell. Market orders let dealers decide your price. In a normal market, market orders are not terrible, but right now nothing is normal about Facebook.